Deferred Tax Meaning Expense Examples Calculation

What is Deferred Tax?

The difference is seen as a deferred tax asset (DTA) or a deferred tax liability (DTL). When the reported income tax exceeds income tax payable, the difference is an asset. When the income tax payable exceeds reported income tax, it becomes a liability for the company.

Key Takeaways

Deferred tax is the gap between income tax determined by the company’s accounting methods and the tax payable determined by tax authorities.Deferred tax arises when there is a difference in the treatment of income, expenses, assets, and liabilities under the company’s accounting procedure and the tax provision.It is the difference between income tax paid and income tax accrued. The difference results in a surplus or deficit.

Deferred Tax Explained

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Deferred tax is the gap between income tax payable and income tax recorded. Sometimes, these differences are temporary—they can be adjusted with subsequent periods. For example, current period business losses can be claimed in the next period—for tax exemptionTax ExemptionTax-exempt refers to excluding an individual’s or corporation’s income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more. But some differences are permanent and cannot be adjusted—penalties charged by tax authorities.

When reported tax exceeds tax payable, it is an asset for the firm. On the other hand, when tax payable exceeds reported tax, it becomes a liability for the business—to be paid off in the future.

The gap between reported tax and tax payable is often caused by the method of charging depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more. Often, the percentage of depreciation charged on the income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more differs from tax statement depreciation values.

Gaps can be brought out by unrealized revenues and unpaid expenses, as well. A company cannot be taxed till it receives revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more. Similarly, an expense cannot be deducted from the tax assessment (current year) till the company actually pays for the expense.

Types

Deferred tax can be broadly categorized into the following two types:

#1 – Deferred Tax Asset (DTA)

Deferred Tax AssetDeferred Tax AssetA deferred tax asset is an asset to the Company that usually arises when either the Company has overpaid taxes or paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the Company or deducted from future taxes.read more (DTA) comes into effect when a company either pays excess tax or pays tax in advance.

DTAs account for the timing difference between book profitBook ProfitBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. read more and taxable profit. Tax regulations allow the deduction of some items from the taxable profits and disallow others. When a company’s book profit exceed taxable profit, it ends up paying more taxes. On the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more, DTA is recorded on the asset side. This way, it can be used to reduce taxable income in the future.

Following are the various DTA scenarios:

When revenue received in advance is taxed before the revenue is recognized, DTA comes into effect.When accounting proceduresAccounting ProceduresThe accounting procedure is the process of standardized nature that performs a specific accounting function designed to incorporate better risk management policies to complete these functions efficiently. It includes billings, invoices to suppliers, bank reconciliation, requiring comprehensive and streamlined procedures.read more and tax provisions treat expenses differently, DTA comes into effect.

#2 – Deferred Tax Liability (DTL)

Deferred tax liabilityDeferred Tax LiabilityDeferred tax liabilities arise to the company due to the timing difference between the accrual of the tax and the date when the company pays the taxes to the tax authorities. This is because taxes get due in one accounting period but are not paid in that period.read more (DTL) comes into effect when the tax payable for the current period has not been paid fully.

When a company’s book profits exceed taxable profits, the tax paid is lower than the reported tax. This becomes a liability for the company. Therefore, DTL is the pending tax amount to be paid in the future.

Different DTL scenarios are as follows:

When tax authorities consider unpaid expenses for a deduction, DTL comes into effect.When a company represents current profits as future earnings, it avoids taxes in the current period. But the same amount becomes a liability for the future.If dual accounting for depreciation and other expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more is undertaken, DTL comes into effect.

Calculation of Deferred Tax

Deferred tax is the difference between tax payable determined by income tax laws and the tax reported by the company’s accounting method Accounting MethodAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more.

Formula

To calculate DTA, we use the following formula:

To calculate DTL, we use the following formula:

In income statements, reported tax is a percentage of gross profit after depreciation. Whereas, for tax statements, tax payable refers to the amount charged on gross profit after depreciation.

To evaluate the taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more based on income and tax statements, we apply the following formula:

Examples

Let us understand the practical application of the concept using examples.

Example #1

Let us assume that a company purchases a new mobile worth $10,000—it has a useful lifeUseful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets.read more of 10 years. The company uses the straight-line method for both income statements and tax statements. However, the company depreciates the asset at 15%, and the income tax department prescribes a 20% depreciation rateDepreciation RateThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company’s long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset’s useful life.read more.

Determine the DTA created because of the difference in rate. The given company reported an EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business’s performance with that of its competitors.read more of $5,000, an interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more of $800, and an effective tax rateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more of 35%.

Solution:

DTA = ($5,000 – 15% * $10,000 – $800) * 35% – ($5,000 – 20% * $10,000 – $800) * 35% = $175

Therefore, the reported DTA at the end of the first year is $175.

Example #2

A company owns equipment with a useful life of four years. The equipment is worth $2,000. The company uses the straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more for depreciation and uses the double-declining methodDouble-declining MethodThe Double Declining Balance Method is one of the accelerated methods used for calculating the depreciation amount to be charged in the company’s income statement. It is determined by multiplying the book value of the asset by the straight-line method’s rate of depreciation and 2read more for tax reporting purposes.

Determine the cumulative DTL reported in the balance at the end of year 1, year 2, year 3, and year 4. For the given company, reported EBITDA and interest expenses are $2,500 and $200, respectively. Also, the applicable tax rate for each year is 35%.

Let us draw a table to capture the effect of deferred tax expenses for each year, along with calculations:

For year one, a DTL is created—book profits exceed taxable profits. However, in year 2, the reported tax is equal to the tax payable.

From year three onwards, reported tax is lower than the tax payable—DTL starts depleting. The reported cumulative tax liabilities stood at $175, $175, $88, and $0 at the end of years 1, 2, 3, and 4, respectively.

What is Deferred Tax?#

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Deferred Tax Explained#

Types#

#1 – Deferred Tax Asset (DTA)#

#2 – Deferred Tax Liability (DTL)#

Calculation of Deferred Tax#

Formula#

Examples#

Example #1#

Example #2#

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